The Dirty Secret of Mining Coin
The world’s best-known cryptocurrency has a dirty secret: the computers that mint new units use tremendous amounts of electricity, often generated by fossil fuels. That real-world cost is one of the factors that gives Bitcoin its value and, more importantly, it is an intrinsic part of how the Bitcoin network works. This process is called mining and it’s essential to the network’s decentralized design.
The cryptocurrencies on the market today are built on a technology known as blockchain. This is a decentralized ledger of all transactions that happens across a network. Groups of approved transactions are verified by miners using complex cryptographic puzzles and then added to the blockchain in a block. These blocks are then chained together, creating a long public record that functions like a running receipt. Miners validate and add these records to the blockchain in exchange for a fixed number of newly minted bitcoins that are awarded on average every 10 minutes.
Each miner uses a special computer to compete with the other miners on the Bitcoin network to guess a cryptographic problem. The first miner to solve this puzzle wins and is awarded the blocks of transactions they verified. The reward of new coins and transaction fees is the incentive for people to spend huge amounts of electricity on this competition. It’s also a crucial component of the blockchain’s decentralized emergent consensus mechanism.
Let’s say Alice buys a cup of coffee from Bob and sends a Bitcoin payment to her friend Jing, who accepts it. That transaction will be included in a block of transactions that is added to the blockchain in a new block 277,316. To validate this new block, a mining computer must be the first to guess a 64-digit hexadecimal number that is unique to the new block. This is a kind of cryptographic lottery that requires enormous computing power and consumes more energy than many people realize.
Once the mining computer spits out a guess, it must then compare it to the hash of the previous block in the chain. If the guess is close enough to the hash of the previous block, then it’s verified and included in the blockchain. Once the new block is included in the blockchain, it is then available to anyone who wants to verify and use it.
This blockchain is constantly growing and adding transactions, but only so many of them can fit in a single block at any given time. To make sure the blockchain doesn’t get bloated, a fixed amount of new bitcoins are “minted” during each verification, which is called mining. Every two10,000 blocks or approximately every four years, this bitcoin issuance rate is reduced by 50%.
If you mine Bitcoin, or any other cryptocurrency, you are taxed the same as you would be if you earned income from any source. The fair market value of the coin at the time you received it will be the basis for your capital gains tax bill, and you must report any profit on your taxes. For more information, check out Bankrate’s cryptocurrency tax guide.